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Pension Funding: To De-Risk or Not to De-Risk

Trend of handing off pension liabilities to insurers is expected to accelerate next year.

Companies that sponsor defined-benefit plans are confronted with a conundrum—whether to de-risk their pension liabilities by transferring them to an insurance company or maintain the liabilities in the hope interest rates will soon rise.

What’s a pension sponsor to do? The answer is not an easy one, and at this juncture sponsors seem to be falling into three different camps. Some are hanging tight waiting for interest rates to rise and their funding status to improve. Others are not making significant changes now, but are committing to implementing de-risking strategies as interest rates and their funding status perk up. For the third, much smaller camp—like General Motors and Verizon—de-risking is the name of the game.

These varying decisions depend in large part on one’s expectations of interest rates rising, and when this might actually occur. If hindsight is a good predictor, the likelihood is certainly not in 2013.

“Some sponsors feel that rates can only go up and they are willing to wait until that day comes, while others think they may stay at current levels for quite some time, and therefore are willing to throw in the towel and de-risk their obligations,” says Richard McEvoy, leader of the financial strategy group at Mercer. “It’s a mixed bag.”

This uncertainty is understandable, as many pension plan sponsors enter 2013 with significant increases in their pension funding deficits, requiring potential balance sheet adjustments and higher P&L expenses. Mercer put the aggregate funded ratio for S&P 1500 companies with plans at 72% at the end of November and estimated their aggregate shortfall was $607 billion. To address these problems, General Motors and Verizon transferred their pension liabilities to Prudential Insurance Co. this year via landmark annuity purchases.

The rationale behind these decisions is compelling: By de-risking, sponsors trade potentially volatile investment activity for a predictable expense—the payment to insurance companies—although that payment carries a premium. “Sponsors can expect roughly a 20% to 30% increase in their pension expenses on their income statements, which is a very broad estimate,” says McEvoy, pictured at left.

Nevertheless, for some companies the premium may be worth it. In addition to a reduction of funded status volatility from mark-to-market gains and losses, they can pare plan expenses related to PBGC premiums, administration and investment costs.

Both Mercer and Vanguard believe the trend of de-risking will accelerate in 2013. “As conditions get worse, we will continue to see more of it,” says Evan Inglis, principal and chief actuary at Vanguard. “Nevertheless, I don’t predict a flood of de-risking. People are wary when interest rates are so low, crossing their fingers they will go up and then the insurance will become less expensive.”

As an analogy, Inglis provides the example of a neighborhood where five houses burn down without any insurance, prompting the remaining uninsured house on the block to buy coverage, even though the premiums are much higher. “It’s just human nature to do something about risk only after it rears,” he comments.

Regarding sponsors that are likely to resist de-risking, Inglis surmises they have more confidence in their funding status and investment expertise. “GM has evolved from an investment perspective to a corporate finance perspective,” he explains. “They wanted stability instead of taking on the equity and interest-rate risks. They make cars—that’s their core competency. They’d rather take risks they know about, as opposed to equity and interest-rate risks that they can’t get a handle on.”

Slightly complicating this decision is MAP-21, the federal “Moving Ahead for Progress in the 21st Century Act,” which eases the higher pension funding obligations produced by historically low interest rates. With regard to MAP 21, both consultants say it will have little impact on de-risking deliberations. “A lot of plan sponsors are taking it with a grain of salt,” Inglis says. “Just because the rules have changed and you can put less money into your plan now doesn’t mean it won’t cost less.”

“It’s hard to tell if sponsors are going to take the relief,” McEvoy says. “We’re seeing many staying the course, understanding they have this relief but knowing the reality of this funding hole they still have to fill.”

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